You likely search for specific metrics when evaluating investment opportunities and are thus already familiar with the various terms, deal structures, and markets that come with quality investment offerings. However, you may not have applied these terms, such as capital stack, NOI, ROI, and IRR, to real estate.
You know that having a deep understanding of a specific topic is crucial in making informed investment decisions. In this article, we will take a closer look at Internal Rate of Return (IRR), its difference from Return on Investment (ROI), how to calculate IRR when evaluating a real estate deal specifically, and why IRR is crucial to consider when investing in real estate syndication deals.
What is the metric, IRR?
IRR is a metric that estimates the profitability of an investment by calculating the rate at which the investment earns or loses money over a specific period. Unlike ROI which calculates the overall return on the investment, IRR calculates the percentage rate of return on the investment based on its cash flows.
As an expert investor, you already know that to calculate IRR, you need to evaluate the expected cash flow of the investment and determine the discounted rate of the investment that makes the Net Present Value (NPV) of those cash flows equal to zero. This calculation provides you with the IRR of the investment.
Considering IRR when evaluating investment opportunities is crucial for expert investors because it provides a more accurate picture of the investment’s profitability. A higher IRR indicates a more profitable investment over time, which is essential when dealing with real estate syndication deals.
Passive Real Estate Investing Myths
First, let’s debunk a couple of myths about real estate syndications. Most would-be-successful syndication investors get stuck on the sidelines simply because they believe these myths:
Myth #1: Lower Control
Some people think when you invest in a real estate syndication, you have less control over the investment asset, thus receiving lower returns. However, as with any passive investment, you exercise your control while you’re reviewing the executive summary and selecting an opportunity that supports your investment goals and risk threshold. Then, you leverage the expertise of a team on the ground to run the business plan while you enjoy the returns.
Myth #2: Lower Return
In continuation of the myth about having lower control with passive investing, people often believe that you’ll have lower returns. Active investors are generally the primary owner, property manager, fully responsible for all gains, and liable for losses too. Meanwhile, with passive investing, you’re able to enjoy all the upside of being invested in real estate like tax benefits, distributions, community improvement, and appreciation while also limiting your liability and maintaining your time freedom.
Now, if you compare IRR across real estate opportunities, this metric can really help illuminate the best deal.
Why Do Real Estate Investors Need IRR And How Does It Help?
IRR (internal rate of return) is the standard metric used to compare the return on your investment with the length of time included in the calculation. In contrast, ROI (return on investment) calculations don’t consider how long it will take to collect your returns.
So, if you invest $100K and earn $300K, it may seem like a good deal.
Before you react, there are a few things to consider. Mainly, the time it would take to collect that $300K should be taken into account. If it took ten years to achieve those returns, I think you’d be less excited than if you could earn those returns in only five years.
The other question is, what return is being reflected by that $300K? Is that overall ROI, or annualized ROI? The shorter the hold period, the higher the annualized ROI while the overall ROI wouldn’t change. So, you’ve got to know what’s being calculated and what factors are being taken into account.
Now, if you’re trying to choose between a five-year value-add opportunity and a seven-year syndication deal, the ROI isn’t very helpful. This is where you need the IRR – so you can include the length of time your capital is invested and accurately compare the returns you might earn.
Keeping It As Simple As Possible
It would be confusing to compare different deals of varying lengths, classes, and types without a clear IRR on each deal. And just in case you’re just dying to relive algebra, here’s the formula:
Don’t worry, though; you don’t have to calculate it yourself unless you want to. Here at Value Partners, we like simplicity. So, we provide IRR along with a chart of other variables so you can see clearly how the IRR may be affected in the financial section of each deal’s investment summary.
Here are some fun facts: The IRR is negative until your returns equal the amount of capital you’ve invested, and then it’s 0%. After that, when your returns surpass the amount of your initial investment, then the percentage starts to grow positively.
The more monthly distributions paid to investors in a shorter timeframe, the faster IRR turns positive. This is why monthly distributions and early sales are popular because they make the IRR skyrocket. Wouldn’t you love to double your money in three years instead of five? I would!
What Variables Impact The IRR?
You may notice an easy-to-find IRR printed in the executive summary, but keep in mind that it’s likely based on the entrance cap rate. The IRR moves as the cap rate moves. This is why we suggest you find the financial section of the investment summary. In the sensitivity analysis, you should be able to see a chart similar to that below, where a varying cap rate, among other factors, reflects an adjusting IRR.
The asset class and strategy also intensely affect the expected IRR on any syndication investment.
A stabilized A-class apartment syndication may have a 7-year term with no refinance opportunity and an IRR between 13%-15%. In contrast, a B-class value-add multifamily syndication may reflect a 5-year business plan, refi opportunity, and forced appreciation from the renovations that push IRR up into the 14%-17% range. Although these are both apartment complexes, possibly even in the same metropolitan area, you’re comparing two different appreciation strategies and two different classes.
Adding streams of income to the property, increasing operational efficiencies, and getting units to market rents are all ways underwriting can affect IRR. Things like laundry services, mail delivery lockboxes, new property management, and payment software for tenants could drastically improve the experience for tenants and support higher rent rates. If per unit and overall property upgrades with generally low cost will increase demand and raise the rental rates, the NOI (net operating income) will get a bump and positively impact the IRR.
What Else To Look For When Comparing Syndication Opportunities
Beyond fancy metrics with three letter acronyms, you should examine each prospective deal for its alignment with your strategy. Consider the types of syndications you’re interested in – multifamily, mobile home parks, developmental, self-storage, etc.
Each varying asset type, class, and market boasts different metrics. Weigh whether the market exhibits high growth trends in favor of increased occupancy and rent rates and decide if you’re comfortable having your investment capital locked in for three, five, or seven years.
Another significant factor is, of course, the operator. Do you agree with their philosophy and the way they run their business? Do you know, love, and trust them? Here at Value Partners, our philosophy includes capital preservation first, followed by preferred distributions, and then appreciation. Therefore, we specifically seek out investment opportunities with these goals in mind.
Other deal metrics to investigate and compare include the breakeven occupancy rate, expense ratio, the deal structure, and loan or debt details. In general, if the breakeven occupancy rate and expense ratio is low, the projections are more likely to be achieved. Deal structures can vary between a wide array of preferred return percentages and splits for distributions, and loans on the property can reflect a wide range of rates, terms, and other options.
As always, your selection should be in line with your values and investment goals, plus within your risk tolerance.
Here at Value Partners, we provide multiple ways to leverage the power of real estate syndications in your investment portfolio so you can take advantage of real estate’s cash flow, equity, appreciation, and tax benefits.
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